Why You Should Brave the Gold Market Selloff

The Daily Reckoning

Sep. 26, 2011, 4:02 PM

Ouch! That hurt!

The "cheap" gold stocks that your California editor highlighted in recent editions of The Daily Reckoning just got cheaper…a lot cheaper, thanks to the largest three-day selloff in gold and silver in nearly 30 years!

The gruesome details are as follows:

Since last Wednesday's New York close of $1,805 an ounce, the gold price tumbled to a low of $1,540 an ounce in Hong Kong last night.

Meanwhile, the silver price crumbled from $40 an ounce in New York last Wednesday to $26 an once in Hong Kong last night.

It is small solace that silver stocks fell less than silver, itself, or that gold and silver have both outperformed the S&P 500 Index for the year-to-date. Gold still clings to a 15% gain for the year-to-date, compared to a 10% loss for the S&P 500 Index and an 18% loss for the MSCI EAFE Index of international stocks.

But as professional investors often observe, "You can't eat relative performance." And that's probably a good thing in this case. Because if you were able to eat this particular serving of relative performance, it would probably taste like shards of glass, blended with rusty needles.

Most folks refer to selloffs of this magnitude as a "correction." We'd call it a lashing, or maybe a keelhauling. A selloff of this size hurts a lot, especially because most holders of precious metals are holding them as a hedge against monetary instability and or/global financial market trauma.

Aren't these the exact conditions we investors are facing right now?

Gold is supposed to be a lifejacket in a sea of turbulence, not a gilded leg iron. In the midst of the current global uncertainty, gold is supposed to buoy portfolios, not plunge them even deeper underwater.

But gold isn't helping at all…or, at least, it didn't help during the last three trading days. This betrayal is enough to shake one's faith in gold - to thrust even the modest ardent gold devotee into a spiral of doubt and self-loathing.

And here's the real shocker: long-dated Treasury securities have provided a much safer safe-haven than the precious metals. "TLT," the ETF that's holds 20-to-30-year Treasury securities is up more than 30% year-to-date. That's right, the debt securities of the now-AA-rated and heavily indebted US government remain the safest safe haven around.

We're not buying it. In fact, we emphatically reject the companion notions that long-dated Treasurys are a safe haven and that the gold market is a busted bubble.

Sharp corrections are never fun, but they are often the "price of admission" to profitable investments. The recent volatility in the precious metals markets demonstrates, once again, that financial assets are volatile assets. And many financial assets - like gold and silver - have become increasingly volatile, thanks to the manic, short-term trading activity of large hedge funds and other institutional traders.

Unfortunately, in a market as small as the gold and silver markets, the trading activities of a few big players can produce extremely volatile effects.

"The amount of paper gold and silver contracts that trade on the futures and equities exchanges still dwarf the amount of actual physical trading that takes place," gold market experts, Eric Sprott and David Baker recently observed. "Paper markets continue to set price discovery - thereby allowing for dramatic volatility with little or no influence from actual physical fundamentals. In the London Bullion Market, for example, market participants traded an average 19.6 million ounces of gold per day in July 2011. Keep in mind that the total gold mine production in 2010, globally, was approximately 86.5 million ounces.

"Global gold mine production is not expected to increase significantly year-over-year," Sprott and Baker continue, "so the London Bullion Market is essentially trading a year's worth of production in less than a week. And this is just one market. When you add the COMEX futures and gold ETFs, the paper trading volume becomes absurdly high. When price discovery is dictated by levered paper contracts with no physical backing, it's extremely easy and relatively inexpensive to jostle the spot price around. The result for gold has been many days of extreme downside volatility, despite a strong and consistent overall upward trend."

In other words, when very large investors (with very short-term investment horizons) become the dominant price setters in the market, the process of price discovery can feel a lot like a price lobotomy.

So what does the selloff in precious metals mean?

Does it mean that the world economy is heading for a depression…and not just a depression, but one that does not trigger a monetary crisis and/or inflationary response from central banks worldwide?

Seems unlikely. If lackluster economic growth is triggering a massive inflationary response form the Federal Reserve and other central banks, wouldn't the prospect of recession or depression trigger an even larger response?

Net-net, we suspect that gold and silver are better bought than sold at today's quotes, at least in the context of a mid- to long-term hedge. But we've been wrong before. In fact, we've been very wrong before.

So let's turn to Bill Bonner, The Daily Reckoning's founding editor. Bill may have been the most reliable voice of reason lately. In several recent editions of The Daily Reckoning, he warned that gold stocks were due for an imminent drop.

"A big sell-off yesterday. The Dow down 283 points. The 10-year T-note yields only 1.87%. And the price of gold barely budged," Bill remarked on the eve of gold's historic three-day selloff, "In our opinion all three should be going down. Because the world is edging towards a global depression…"

One day earlier, Bill remarked:

Could gold be finally testing its admirers? Though still in a major bull market, could it be correcting…possibly falling back to the $1,000-$1,500 range?

Yes it could. Gold's time will come. But we don't think it is here yet. Gold has risen in anticipation of trouble. But the trouble gold buyers foresaw hasn't come…not yet. There's been massive money-printing. Still, in terms of the goods and services it will buy, gold has held up pretty well.

Gold will take off - when the anticipated trouble becomes real here-and-now trouble. And that probably won't happen for a while.

Bill made very similar remarks throughout late August and early September. So kudos to the Chief on a great call. But no one really knows when anticipated trouble will become "real here-and-now trouble."

So if it's trouble we anticipate, better to invest before the fact than after it, no matter how painful the waiting game might be.

In the September 19 issue of Barron's, an interviewer asked James Grant, editor of Grant's Interest Rate Observer, whether the gold market was in a bubble. Grant replied:

"A bubble is a bull market in which the user of the word 'bubble' has not fully participated. You can think of gold as a stock that went from 2 5/8 to 18 in a dozen years. I'm not sure that's a bubble… What I do think is gold is simply the reciprocal of the world's faith in the institution of managed currencies. It is one divided by T, where T stands for trust. And trust is a shrinking number and will continue to shrink. Therefore, I am bullish on gold."

So is your California editor, even if the gold price falls again tomorrow.